213. The price of risk – a City of London view

For someone
On top of the world
The view is not exactly clear
Evita — Rice & Lloyd-Webber (1976)

I spent much of the summer visiting financial institutions in the City of London.

The fallout from last autumn’s global economic meltdown is still drifting through our streets. The world didn’t end last October, but it felt a close call at times.

For the moment, it seems as if the worst is behind us. The dust is clearing slowly, and yet in the City uncertainty still clouds a faintly growing optimism. For many in the Square Mile, waiting out the storm a while remains the wisest game of all.

When recovery comes, what will it look like? Or is it here already, lurking in the lunchtime swagger of those traders who survived the carnage, and the evening calm of bankers working now for different masters?

Looking back, the causes of this crisis are clear to see. It was all about the price of risk.

In 2007, the City thought it had abolished risk, or at least knew how to measure it.
That was an age-old mistake, repeated in almost every global financial failure that ever happened, from the South Sea Bubble of 1720 to the collapse of the hedge fund Long Term Capital Management during the Russian Financial Crisis in 1998.

JK Galbraith’s excellent primer The Great Crash of 1929 provides a clear account of the most famous stockmarket meltdown of them all.

And reading Galbraith this summer, the parallels between 1928 and 2007 were quite uncanny. A new financial product (for the Investment Trusts of 1928 you can read the CDOs of 2007) had opened up an endlessly rich seam of money.

Leverage grew on the back of leverage, in the safe knowledge that financial risk had been abolished. Except, of course, it hadn’t.

Financial memories are famously short, and reports of an improving economic environment this autumn suggest that even the hard lessons from last year may yet be soon forgotten. Or will they?

The Great Crash was followed by almost a decade of economic suffering. The stock market reached its lowest point in 1932, three years after the crash began.

So if economists think they can glimpse an end to this recession already, what’s the difference, this time? Two things.

The first of these is policy. We’ve learned (at least in theory) from mistakes made in the past.

Our leaders have recognised that in times of crisis, economic prudence must be balanced out with pragmatism.

They’ve understood that the banking system must be supported, and the economy stimulated towards recovery if deflation is to be avoided.

But policy has a cost, as we’ve seen through all the bail-outs. Estimates last week suggested that the US national debt has now risen to $29,000 for every citizen. That must be paid for somehow, by higher taxes and cuts in public services.

The same applies in Britain. We’ll safeguard the jobs of teachers, doctors and nurses as best we can, so the NHS and our schools and universities will survive. But investment will be slashed, and there’ll be cuts in services and investment right throughout the supply chain.

And there’s the second difference that I can see. This time, most pain will be felt not in financial services, nor even by investors. The slow stock market recovery now underway may yet claw back the losses of all but the unluckiest speculators.

No, the axe will fall much further down the tree, in the public sector and amongst smaller companies and their employees — especially those who offer support and supplies to government and public institutions.

This new and wider wave of pain is only now beginning.

Meanwhile, atop the towers in the City of London, the horizon might not look exactly clear, but it’s certainly much brighter. The banks may be lending cautiously, for now, but they’re back on the path to profit.

Policy has stemmed the tide. The banking system was saved, and the City was rescued from ruin to invest another day, if still cautiously for now.

The bail-outs have seen the pain passed from investors to governments, and the cost will be paid for over years to come, by many ordinary employees in wholly blameless occupations, far removed from the financial sector.

So there we have it. The global financial crisis of 2008, like nearly every crash before it, was all about misjudgement of the price of risk. But as the view from the City of London clears, who will pay the price of so much miscalculation?

It’s not the banks — not really.

Because the cost of a systemic financial failure, this time, has been transferred transparently to all of us — and that means you and me.

The latest issue of the BBC’s City Diaries is well worth a read along with this article. Far from seeing the recession as over, and the problems as swiftly solved, those working in the City appear increasingly damning of a return to the old ways and delusions of the days before the crash.

The FTSE is still securely above 5,000 today — if not confirming that the worst is over, then pointing to a time a few months ahead when it will be.

But when you read the insiders’ views, it’s not quite so clear that this is really true. Can slowly rising confidence alone pull us out of the recession without significant structural and regulatory changes being put in place?

I suspect they can. But they may not be able to keep us there, and I’m especially wary of one correspondent’s comment there to the effect that ‘the next crash will make this one look tiny.’